The usefulness of accounting estimates for predicting cash flows and earnings |
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Authors: | Baruch Lev Siyi Li Theodore Sougiannis |
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Institution: | (1) Stern School of Business, New York University, 44 West 4th Street, New York, NY 10012, USA;(2) Department of Accountancy, University of Illinois at Urbana-Champaign, Champaign, IL 61820, USA;(3) Athens Laboratory of Business Administration (ALBA), Vouliagmeni, 16671, Greece |
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Abstract: | Accounting estimates and projections potentially improve the relevance of financial information by providing managers a venue
to convey to investors forward-looking, inside information. The quality of financial information is, however, compromised
by the increasing difficulty of making reliable estimates and forecasts and the frequent managerial misuse of estimates. Given
the ever-increasing prevalence of estimates in accounting data, particularly due to the move to fair value accounting, whether
these opposing forces result in an improvement in the quality of financial information is among the most fundamental issues
in accounting. We examine the contribution of accounting estimates embedded in accruals to the quality of financial information,
as reflected by their usefulness in the prediction of enterprise cash flows and earnings. Our out-of-sample prediction tests indicate that accounting estimates beyond those in working capital items (excluding inventory) do not improve
the prediction of cash flows. Estimates do, however, improve the prediction of next year’s earnings, though not of subsequent
years’ earnings. We conclude that the usefulness of accounting estimates to investors is limited and provide suggestions for
improving the usefulness of estimates. |
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